The Week Ahead updated December 18, 2009
- Cautious on further USD upside, but JPY may play catch-up - Fed wearing rose-colored glasses again - Cable likely to reflect the weight of poor sterling fundamentals - Key data and events to watch next week
N.B. This week's report has been finalized earlier than normal, around noon EST. As such, readers should be aware that we do not have the benefit of knowing the daily/weekly closing price levels, and any price points we cite should be interpreted in light of those closing levels.
Cautious on further USD upside, but JPY may play catch-up
The greenback has extended its recovery, bringing the USD rebound against the EUR to nearly 6% since the 1.5150 high at the end of November, and erasing all the losses seen in the 4Q. The current environment continues to develop into a perfect storm against the EUR in particular, and indeed that is where the dollar has gained the most. Credit concerns continue to pressure the EUR, with Austria nationalizing a small regional bank at the start of the week (and placing the 4th largest bank under surveillance) and a ratings cut to Greek sovereign ratings coming mid-week. To finish out the week, Friday saw the ECB increase its forecast of Eurozone bank write downs by a further 13%. The sharp rebound in the USD has caught global reserve managers off guard, and anecdotal evidence (market chatter) suggests they are increasingly pulling back from plans to sell dollars and may be moving to the other side, looking to sell EUR/USD on any rebound. In Japan, the BOJ has declared war on deflation and that promises to keep pressure on Japanese rates in the near-term, increasing the JPY's appeal as the primary funding currency for carry trades. US rates on the other hand, look to have peaked in the short-term, with 10-year yields cresting just above 3.60% and since dropping back to around 3.50%; two year note yields peaked just below 0.90% and have since dropped back to around 0.75%.
Excessive USD-short position squaring/reduction helped propel the USD off its lows, but changes in short-term interest rates were the other principal driver. COTR data from last week (as of 12/8) suggests much of the USD short positions have been exited (small EUR/USD net shorts were actually reported) and US rates have stalled in their rise after the Fed renewed its commitment to exceptionally low rates for an 'extended period.' As such, two of the main sources of recent USD strength are beginning to fade and this gives us cause to pause on further USD strength. Additionally, the negative Eurozone news is somewhat overblown and we think the market has overreacted on the EUR. Lastly, the USD has risen to levels where longer-term USD bears see an opportunity to re-enter dollar shorts. The exception is in USD/JPY, which we think may play catch-up (rising) in the weeks ahead and dominate price moves into year-end. On the other side, an element of year-end inertia is at work, and an object in motion (rising USD) is likely to stay in motion. Overall, we would be extremely cautious on holding USD longs (except against the JPY, where we remain buyers on dips) from current levels, but would look to re-buy USD on pullbacks, looking to re-sell EUR/USD in the 1.4380/1.4430 area, GBP/USD around 1.6350/400. Finally, we would remind traders that holiday-thinned markets in the final two weeks of 2009 will exacerbate volatility and increase the chances for potentially erratic price moves, which suggests adopting more defensive/protective tactics.
On the technical front, we have also reached price levels that suggest caution on chasing the USD higher from here. In favor of further EUR/USD weakness, we have decisively broken below the daily Ichimoku cloud, the base of which is up at 1.4627, suggesting a trend shift lower. The guiding trend line is a steeply falling line that starts next week at 1.4395/00, and declines about 60 points each day, which we will be watching closely as a key to exit EUR shorts. On the downside, we have identified the 1.4250/4300 as a key zone of congestion support, with the 100-week sma a key weekly close level at 1.4311. More concretely, just below is the 200-day sma at 1.4181 and the top of the weekly Ichimoku cloud at 1.4184. The 1.4170/80 level is also the bottom of the September consolidation range. Overall, current conditions suggest a scenario where EUR/USD makes a final plunge to the 1.4150/80 area and then bounces/consolidates. In USD/JPY, price is struggling to close above the daily Ichimoku cloud top at 90.66, but the outlook remains constructive while above the daily Tenkan and Kijun lines at 89.14 and 87.90, respectively.
Fed wearing rose-colored glasses again
The FOMC's track record on forecasting should give those that are looking through the same rose-colored glasses some pause. Recall that Bernanke and company called the end of the housing market problems back in early 2007 and were proven dead wrong. The Fed noted in their January 31, 2007 communiqué that some tentative signs of stabilization have appeared in the housing market. Home prices back then had yet to dip into negative terrain and over the next two years would fall to -19% year/year. Two months later, they were forced to renege and noted that the adjustment in the housing sector is ongoing. Quite a failure in forecasting from the body that purportedly has the best econometric models in the world.
The Fed statement this week showed a notable mark-up in terms of where the committee sees the US economy at the moment. Most importantly, they ratcheted up their optimism on the labor market and were more upbeat on housing. The business picture still looks gloomy according to the Fed and this is about the only assessment we can agree on. The short-term risk for the bulls is that the Fed proves to be overly optimistic - again.
The notion that deterioration in the labor market is abating can be called into question even if we only look at the data from this week. Initial jobless claims jumped to a higher than anticipated 480K, but that was only the tip of the iceberg. The real story was the jump in total continuing claims. Indeed, the tally of those on state and federal unemployment programs rose to a new record 10.1 million from 9.4 million the prior week. This flies in the face of the decline in the unemployment rate in November and goes against the Fed's notion that we are seeing improvement on this front.
On the residential real estate front, the Fed is also more sanguine. Their view is that the housing sector has shown some signs of improvement of late. The NAHB index (homebuilder sentiment) would beg to differ. Total activity dropped to 16 in December from 17 last month and 19 in September. This is the worst print since June, but the bad news doesn't end there. Prospective buyer traffic, which is a great indicator of demand, remained depressed at 13 for the third consecutive month - this number was sitting well above 50 in the rip-roaring subprime days. Demand will only get thinner if we get a pop in mortgage yields once the Fed stops buying MBS securities in 1Q.
The one part the Fed looks to have gotten right is that businesses are still cutting back on fixed investment. Regional manufacturing surveys from NY and Philadelphia this week proved that the business sector remains stressed. The most glaring problem is the major margin compression that firms are suffering. The NY Empire showed prices paid in the region rose to 19.7 from 10.5 while priced received slipped to -9.2 from -2.6. In the Philly district, prices paid soared to 33.8 from 14.9 while received dropped to -1.8 from -1.5. So firms are seeing a major increase in the prices of things they buy while having to cut selling prices as they struggle to unload inventories in an environment where the consumer is in full deleveraging mode. One doesn't have to be a mathematician to know that this will hurt 4Q earnings in size.
Cable likely to reflect the weight of poor sterling fundamentals
The 1.6% drop in cable since the start of December is far more moderate than the 4.4% decline that has been registered by EUR/USD. The EUR's underperformance of both the USD and the pound this month reflects the weight of sovereign deficit issues which have recently been dogging the Eurozone. These issues are likely to help the USD cyclical recovery vs. the EUR and could potentially allow EUR/GBP to hold its present lower levels going forward. That said the outlook for the UK remains mired by its own weight set of problems. While better than expected labor market data over the last couple of months have brought the first pieces of really good news for the UK since the start of the recession, the issues surrounding the weighty budget deficit and slow growth are likely to continue weighing on the pound going forward and the cable is likely to reflect most of this weakness.
UK November public sector borrowing totaled GBP20.3 bln. The cumulative total for the first eight months of this fiscal year is GBP106.4 bln. This compares with GBP 49.3 bln in the same stage last year and suggests that there is risk that the Chancellor's whopping full year estimate of GBP170 bln could prove to be overly conservative. Despite the hefty deficit, the Chancellor was reluctant to announce many true deficit cutting measures in this month's pre-budget report. The official reason was that the meager growth outlook needed to be supported. The fact that the general election will most likely be held in May 2010 offers another explanation. The markets are unlikely to reward sterling for the Chancellor's reluctance to face the budget deficit head-on, nor is the market likely to reward sterling for the continued poor UK growth backdrop. The upcoming release of final Q3 GDP is expected to confirm that the UK remained in recession during the quarter (median -0.3% q/q). Growth is expected to have resumed during Q4. However, the recent disappointing release of Nov retail sales (-0.3% m/m) highlights the continued vulnerable position of consumer sector. The forthcoming release of the minutes of the Dec BoE meeting should shine fresh light on the MPC's view of economy. In all likelihood, however, the risk of further QE will remain on the table until February and there will be little to disregard the view that BoE rates will remain at their present 0.5% level until the second half of 2010. We would expect GBP/USD to retest the 1.6100 support near-term and see scope for a move back towards the 200 day sma at 1.6000.
Key data and events to watch next week
Global markets are likely to be in holiday mode next week but there are still some important pieces of data due out. That coupled with what tends to be very thin markets this time of year (low volume), could make for some very interesting price action. Please note that we will be closing for the Christmas holiday on Thursday, December 24 at 10pm ET and reopening Sunday normal time.
In the United States, the typically under-the-radar Chicago Fed National Activity Index is due on Monday. This metric does a good job predicting expansions and it is worrisome that it has now fallen three months in a row. The final cut of 3Q GDP is due on Tuesday along with existing home sales. Wednesday is busy with personal income/spending, University of Michigan consumer sentiment and new home sales. Thursday rounds out the week with durable goods orders and the usual initial jobless claims data.
It is data-light in the Eurozone. Germany sees consumer confidence on Tuesday and import prices on Wednesday. Meanwhile, France has producer prices on Tuesday, consumer spending on Wednesday and employment on Thursday.
The UK has a very thin calendar. The final 3Q GDP cut is up on Tuesday and the Bank of England minutes are due Wednesday.
Japan is busier than most other countries. The Bank of Japan's monthly report kicks off the action on Monday while Tuesday sees small business confidence and supermarket sales. The BoJ minutes are the highlight for Wednesday. Thursday brings employment and consumer prices while Friday closes out the week with housing starts.
In Canada, only retail sales on Monday and monthly GDP on Wednesday are noteworthy.It's super-light down under as well with Australia leading index on Monday and New Zealand GDP on Tuesday.